The Role of Profit Rate in Islamic Monetary Policy

The Role of Profit Rate in Islamic Monetary Policy

Trisiladi Suprijanto (Ibn Khaldun University, Indonesia)
DOI: 10.4018/978-1-7998-0218-1.ch002

Abstract

Extensive research has been done regarding the Islamic pricing benchmark, both in terms of the Islamic jurisprudence (Fiqh) and Islamic economic perspectives. However, there is no in-depth study on the substitution of the interest rate concept to date in the application on the Islamic banking pricing product. This chapter will initiate the difference between the concepts of rate of profit, rate of interest, and practice in the field. Some jurists from the Middle East allow the use of a benchmark rate, such as the London Inter-bank Offered Rate (LIBOR), as a measure of Islamic financial asset prices. They equate the concept of rate of interest with the concept of rate of profit. This is the core reason (raison d'être) for the replacement of usury as instructed in the Qur'an. This study will discuss a financial asset pricing methodology in accordance with the core principles of Islam.
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Background: The Aim Of The Study

The abolition of interest in the Islamic financial system requires an applicative replacement concept of interest in the operational level of Islamic financial institutions in accordance with Islamic principles. The applicative replacement concept of interest according to the Qur’an (QS 2:275) has been mentioned as profit that derived from commercial transaction without any exploitation. In Islamic economic literature, among others, it is referred to as the (expected) rate of profit. Some conventional and classical economists, including von Neumann (1946) and Sraffa (1960), also call it the rate of profit. The neo-classical economist, Thornton (1965), calls the concept the marginal rate of profit. Wicksell (1934) mentions the concept as the natural rate of profit.

There is disagreement among conventional and Islamic economists regarding the concept of thought. In the applicative level, the concept of rate of profit as a replacement of the concept of interest is very important at both the macro-economy and micro-economy levels, especially for setting up the Islamic financial system. This issue is important because Islamic economists do not have a clear concept on the rate of profit.

At the macro-economy level, the application of the rate of profit is practiced at central banks in countries that have implemented a dual banking system or fully Islamic economic system (single economic system). Monetary policy and product differ. Central banks have used different contracts in creating and using the instruments of monetary control. In the level of practice of the Islamic financial system, there is a difference of opinion about the use of contract agreements in the monetary instrument, namely countries with monetary instruments with a rate of profit which is determined based on profit sharing (ex-post) and countries with monetary instruments with the rate of profit using sale-based products (ex-ante).

Countries that implement monetary instruments with an ex-post rate of profit include Sudan, Iran, and Pakistan (with the contract Musharakah and Mudarabah). Countries that implement monetary instruments with the rate of profit which is determined in front (ex-ante) include Malaysia (the contract bay' al-'inah and Murabahah) and Indonesia (the contract of Repo or repurchase agreement). According to the author, differences in the use of monetary instruments are due to differing views on the effectiveness of monetary policy to control money supply (Rafay & Saqib, 2019). Instruments with a rate of profit which is determined in advance are considered by many experts as more effective in attracting money in circulation.

At the micro-economy level, the application of the rate of profit faces problems because there is no yardstick (or benchmark) in the determination of the profit margin/mark-up on the contract of the sale-based product (Murabahah) and the cost of renting the contract (Ijarah). Additionally, there is a difference in the calculation on the concept of rate of profit on the contract of Murabahah and Ijarah.

Some Muslim countries apply margin/mark-up on Murabahah and Ijarah in advance (ex-ante) and fixed for the long term. Others apply this in the short term. In Pakistan, Murabahah as a fixed margin can be used in the short term, medium term, or long term. In Bangladesh, the contract Murabahah is used for short-term transactions; Bay 'muajjal is used as installments for the purchase of long-term assets. In the United Kingdom, the contract Murabahah is even used in home financing transactions over an extended period of 20 to 25 years.

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